A Fed Strategy to Make Everyone Happy
What You Missed
Sandwiched between the debt ceiling excitement and this coming week’s Fed meeting, last week’s data and events did little to change the economic or interest rate outlook. America’s economy is likely softer than the latest jobs, income and consumption data suggest, and last week’s limited data corroborated that view.
Running the Numbers: Positioning Ahead of Fed Meeting
Rates across the maturity spectrum mostly ended the week higher in a quiet trading week. The crosscurrents of a persistently robust jobs market, stubbornly high inflation, and tightening lending standards continue to dominate rate moves. For the week, the 2, 5, 10 and 30-year Treasury yields rose a respective 11, 8, 5 and -1 basis points. Pressure persisted in the 2s-10s Treasury yield spread, a widely watched barometer of recession potential, to trade at -84 basis points, in the middle of the recent range of -108 a couple of months ago and -55 seen a few weeks ago.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, traded in a tight range to 5.25%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 23 basis points week over week, to 4.22%, reflecting the ongoing uncertainty surrounding the path of the Fed’s rate hiking campaign.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its 5.25% peak, and expects it to decline over the next year as the Fed eventually eases. Swap markets once again scaled back their prediction of rate cuts by the end of this year, now pricing around 25 basis points in rate cuts – back from 30 basis points two weeks ago – before the end of the year, reflecting the seeming resilience of the US economy, but one that falls into a recession in the fall.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell slightly week over week, on the back of the resolution of the debt ceiling saga. Elsewhere, equities were slightly lower in the week. The price of a barrel of West Texas Intermediate crude oil fell $3 to $68.02, while the US Dollar weakened, and gold traded flat.
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.
Service Sector is Decelerating – Just What the Fed is Hoping For
Via the May ISM Services data, released last week, activity in the service sector decelerated in May as demand weakened and businesses became increasingly concerned over a sluggish economy.
Why you should care: Consumer purchases of goods and services are responsible for just over 70% of US economic activity, and as the consumer goes, so does the economy. The services ISM index declined 1.6 points in May (50.3 vs. 51.9 prior), coming in below the consensus forecast (52.4).
Two forward-looking parts of the services data – new orders (52.9 in May vs. 56.1 prior) and business activity (51.5 vs. 52.0 prior) both declined. Both indices, however, remained in expansionary territory, implying that demand for services is still growing, albeit at a much slower pace. The pullback was mostly brought on by a decline in services employment (49.2 vs. 50.8 prior) and improvements in capacity and delivery times, both of which are byproducts of weak demand. Layer in the manufacturing activity data from a couple of weeks back, that also showed a decline in manufacturing for the seventh straight month, and you have clear evidence of a slowing US economy.
If you’re a bit nerdy about this stuff like we are, let us take you down the rabbit hole for a moment. Rail-freight carloads and corrugated-box shipments, two forward-looking indicators of consumer demand, that have proven accurate over the years, both point to a softening of demand in the months ahead. May had the biggest drop in railcar loadings since August 2009, a 16% decrease in the three-month moving average on an annual basis. This index declined early in 2022 before remaining largely constant until January 2023. Corrugated-box shipments – which serve as a predictor of the level of retail sales in large stores by three to six months – have declined significantly in recent months.
Our take: It’s becoming clear that supply and demand are coming into greater balance and that the torrid, post-Covid growth spurt is on its last leg. This is further evidence that the Fed’s 5.00% of cumulative rate hikes since March 2022 is working its way through the economy – with a long lag – and that we’ll see more slowing in the months ahead, likely leading to a formal recession later this year.
Other Central Banks Are Still Hiking, Giving the Fed Room to Do the Same
While there haven’t been many macro catalysts in the US this past week, there have been many intriguing happenings elsewhere. The Reserve Bank of Australia and Bank of Canada, two organizations that allegedly withdrew to the rate hikes sidelines a few months ago, surprised markets by hiking rates with no warning.
Our take: The obvious inference in regards to the Fed is that any rate hike pause it chooses to take this week does not necessarily signal that it’s at the end of its hiking cycle. However, the Fed does stand out from other central banks in a significant way: it hates surprising financial markets. Of the five major central banks (The Bank of Japan, The Bank of England, The European Central Bank, The Bank of Canada, and The Royal Bank of Australia), the Fed has generated the smallest average surprise relative to market expectations over the past 15 years. Said another way, if the Fed does pause rate hikes this week, but chooses to hike again down the road, it will be well telegraphed ahead of time.
Layoff Announcements are Coming to Fruition: Jobless Claims Explode
Weekly initial claims for unemployment rose by 28k to 261k last week, suggesting that previously announced layoff plans by businesses are happening. Although one always must resist the urge to turn one week’s worth of data into a “trend”, a sizable softening of the jobs market could start to shift the Fed’s focus away from inflation and toward creating maximum employment. We’ll need to see a lot more pain in the jobs market before that’s likely to happen; for now, the Fed is still totally committed to achieving its 2% inflation objective.
What to Watch This Week – A Fed Strategy to Keep Everyone Happy
For the first time since it started its aggressive rate-hiking cycle in March 2022, the Fed is likely to keep rates on hold at 5.25% (upper-bound) at this Wednesday’s monetary policy meeting. In what is being called a “hawkish-skip” by many in financial markets, Fed Chair Powell and Co. will likely uphold their preference for hiking rates again at its next meeting on July 26th. The Fed will also release an update to its
dot plot this week, which will back up the market’s expectation of a hawkish-skip by implying that Fed members expect inflation risks and interest rates to head higher, implying one more rate hike this year. Specifically, the updated dot plot will probably reveal that the median participant increased their predicted fed funds rate to 5.3% (from 5.1% before; it’s 5.25% now) for year-end 2023, 4.4% (from 4.3% prior), and 3.3% (from 3.1% prior) in 2024 and 2025, respectively.
Since the Fed has insisted that it is too early to seriously consider cutting rates this year, markets no longer anticipate more than one cut. Even so, there are many wagers in the options markets and elsewhere that a slowdown in the economy will require cutting to keep the economy out of a deep recession.
Thus, the reaction may be more influenced by the Fed’s update to its economic forecasts and Powell’s tone during the post-meeting press conference. Market bets on a Fed pivot toward rate cuts would increase if the Fed implies that financial conditions have peaked, but a more robust set of economic forecasts would encourage market bets for no pivot, and toward rates being higher-for-longer.
However, tension inside the Fed’s voting committee is growing. Given the lengthy and unpredictable delays of monetary policy, those who would rather forgo a hike in June prefer to wait and observe how the 500 basis points of rate hikes to date have cooled the economy. More aggressive committee members believe that because rates aren’t squeezing inflation and economic growth fast enough, the Fed shouldn’t take the chance of falling behind. The Fed’s “hawkish skip” is a strategy that will keep everyone on the committee happy – for now.
Even so, the Fed may face additional evidence of stubbornly high inflation and a softening economy by the time it meets again in July, warranting another 0.25% rate hike, likely its last. Alternative indicators, such as a decline in consumer demand and spending (retail sales, Thursday), and a sharply softer headline inflation reading (Consumer price index -CPI, Tuesday, the first day of the Fed meeting; Producer Price Index – PPI, Wednesday), should give the Fed confidence that things are headed in the right direction and that a pause is justified. While all that sounds good, we suspect that only large job losses / a large rise in unemployment will drag inflation down to a level that’s anywhere near the Fed’s 2% target (it’s 5.5% now).
In the meantime, we’re keeping a close eye on Tuesday’s CPI (inflation) gauge, which is due on the first day of the Fed meeting. A blowout reading could force policymakers to hike regardless of the market’s “hawkish pivot” expectation.
Strategy Corner – Construction Loan
Situation: You’re presented with a term sheet for a $50MM, 3-year construction loan where the lender requires the borrower purchase a 1-month term SOFR interest rate cap for the full $50MM loan amount, struck at 4.50%.
Even though the lender is requiring that the rate cap be for $50mm in concert with the loan, the first year of the loan has an “accreting” draw schedule of $4,166,667 per month.
View: There’s a thought that the rate cap may cost less if its $50MM notional is synced with the draw schedule. When rates and volatility were at all-time lows before the pandemic, structuring the cap in that way often didn’t yield any cost benefit to the borrower.
Times have changed. Given the inversion of the SOFR forward curve, such a structure yields great cost benefit to the borrower. For example, for an accrual period running from 7-1-23 to 8-1-23, 1M SOFR is expected to be 5.20%. For a 3-year loan, the inverted forward curve implies that 1M SOFR will reset at 2.97% for the final accrual period from 6-1-26 to 7-1-26.
This dynamic implies that, by buying a rate cap with a $50MM notional as the lender is requring, the borrower is severely over-hedged and will pay through the nose for the rate cap.
Strategy: Structure the cap with an accreting notional schedule that syncs with the draw schedule, saving the borrower singnificantly on the cost of the rate cap in the process.
In our experience, involving an advisor to assist in your hedging decision is a critical component to a favorable outcome for both lender and borrower. By working in tandem with the lender – and providing analysis to justify the hedge structure – the advisor ensures that both parties, lender and borrower, end up in the best risk and cost position possible.
Real world analysis, with data to back it up provided by the advisor, is just what the underwriter wants. The underwriter isn’t going to do the analysis for you. Let our team’s extensive capital markets experience provide solutions for your particular hedging needs.
Whether or not this strategy works for your specific situation requires some analysis. Curious? Reach out to us: firstname.lastname@example.org or 415-510-2100.
Current Select Interest Rates:
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Source for all: Bloomberg Professional